Why Oil is about to hit troubled waters

Last updated Jan 17, 2018

Brent crude briefly topped $70 a barrel last week, its highest since November 2014, and the obvious question was when would the shale drillers turn on the taps. The better question this time around is what will happen to demand and volatility in the oil market.

Brent crude briefly topped $70 a barrel last week, its highest since November 2014, and the obvious question was when would the shale drillers turn on the taps. The better question this time around is what will happen to demand and volatility in the oil market.

The supply argument is the easy one and both big drivers point to an increase in crude. This dynamic has dominated oil markets since the “sheikhs vs shale” showdown began around four years ago, sending oil into a sharp year-and-a-half long swoon. Only the numbers have changed. Once upon a time, it seemed that when oil fell to $70, U.S. frackers would lose money and stop drilling. Since then, shale producers have gotten more efficient, so with the price at $70, expect more U.S. supply.

The U.S. Energy Information Administration just updated its forecast for U.S. production in 2018 to 10.3 million barrels a day, a full million barrels higher than its forecast this time a year ago. That would be a new annual record, eclipsing the 1970 high. If production does keep rising, it will likely remain high until late 2018, whatever the price does.

The other supply factor is the output deal between the Organization of the Petroleum Exporting Countries and Russia. The participants extended their deal through 2018, but the $70 crude price makes an early end to the agreement more likely.

The other side of the equation tells a different story. Right now, bullish speculative bets on oil futures are at their highest level ever. Typically that is a sign of overconfidence and the market tends to fall.

There are some potential geopolitical triggers for a sharp rally such as political instability in Saudi Arabia or Iran, an open conflict between the regional rivals or a spillover from their proxy contest in Yemen to nearby crude transport waterways. Finally, Venezuela’s deteriorating output could turn into an outright collapse given unrest there.

Consumption growth would seem obvious given the booming global economy. Yet much of the recent gains can be pinned on China, which has been aggressively filling commercial and government inventories. Analysts wonder if a lack of storage space will lead to a sharp slowdown. OPEC itself sees Chinese demand growth this year being the slowest since the crisis year of 2008.

End-user demand could slip too. Passenger car sales in China rose at their slowest pace in well over a decade in 2017, according to official statistics, and two-thirds of that growth came from electric vehicles. An economic slowdown in China would be far worse with a potentially 2014-like effect on crude prices.

The physical oil market may have reached some sort of equilibrium, but don’t assume prices have.